The Stochastic is another momentum oscillator indicator which is highly popular amongst traders. It was originally developed by George C. Lane back in the 1950’s. Lane was quoted as saying, “Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.”
This indicator calculates the position of the current price in relation to the highest high and the lowest low of the last n bars. The idea being that when the market is trending up, price is closer to the highs of the bars and when the market is trending down price tends to be closer to the lows of the bars.
The Stochastic uses a scale from 0 to 100 and has an Overbought line at 80 and an Oversold line at 20.
There are two speeds of Stochastics that are available – Fast and Slow – one being a derivative of the other.
For the Fast Stochastic we want to take the highest high and the lowest low of the past n bars like so:
%K = (CurrentPrice – Lowest(Low, n)) / (Highest(High, n) – Lowest(Low, n)) * 100;
%K represents the Stochastic. The n is period lookback used and is usually set to 14 by default.
There is another plot called the %D which Lane contended was good to find divergence in the market. The %D is calculated simply by averaging the %K as follows:
%D = Average(%K, n);
The n in this case is typically set to 3 by default.
Given the focus on the Fast %D for divergence, the Slow Stochastic was created to emphasize its importance. To do this version, you continue with the formula above by doing:
Slow%K = %D;
Slow%D = Average(Slow%K, n);
As you can see, to make the Slow Stochastic, we simply get the %D from the fast stochastic and use it as the Slow%K and then we smooth the Slow%K to make the Slow%D. Like the Fast Stochastic, the typical period (n) used for the Slow%D is 3 by default. This effectively smooths out a lot of the noise of the faster version.
Fast %K = %K basic calculation
Fast %D = 3 period average of Fast %K
Slow %K = Fast % D
Slow %D = 3 period average of Slow %K
Like I say for all oscillators, do not expect the market to reverse when the oscillator tells you it is Overbought or Oversold – they could stay that way for a LONG time if there is a lot of buying or selling pressure. However, the Stochastic is real good at showing a decline of momentum.
Stochastic is very good at showing a divergence in the market – for instance in an uptrend the market is making higher highs but the Stochastic is making lower highs – THAT is a divergence and usually means the market is getting tired and about to reverse. The same goes for lower lows in the market and higher lows in the Stochastic – a signal that the market could be ready for a reversal to the upside.
Sometimes traders like to treat the %D as a trigger line – for instance, when the %K crosses over the %D and the 20 line, there is a Long condition. Likewise, when the %K crossed under the %D and the 80 line, there is a Short condition. However be cautioned in that this doesn’t happen all the time. When there is a strong trend, a cross of the %D can be a fake out.